A covered call strategy for income is often the easiest way to make a living from trading. For those unfamiliar, a call option is a contract between two speculators, traders, or investors. The buyer of the call option gets the right, but not the obligation, to purchase 100 shares of stock from the seller at a certain price (called the strike price) for a certain period (called the maturity date), all of which is specified in the call option contract. In exchange for selling the call option the seller gets paid a premium. The premium is determined by a fancy formula that considers the historical and projected volatility of the stock price, how far away the strike price is from the current price, and the risk-free interest rate. The basic idea is that the farther out the maturity date, the more volatile the stock, and the closer the strike price is to the current price, the more money you’ll get for selling a call option.
Covered Calls for Beginners
A covered call strategy for income involves selling a call option on shares of stock you already own. Each call option is for 100 shares of stock so to sell one call option you’ll need to own 100 shares for a covered call. To sell two call options you’ll need to own 200 shares, and so on. Covered calls for beginners often involves an investor selling a call that expires in three months or less with a strike price that is two to five percent above the current price. And then that process is blindly repeated until the stock price is above the strike price at expiration and gets called away. I.e., the seller of the call option must deliver 100 shares of the stock they own for each call option sold to the buyer of the call option. The buyer of the call option, after he has paid for the 100 shares using the formula 100 x strike price and the stock has been delivered, can either hold onto it and hope for additional gains or sell it immediately at the open the next day and pocket the difference between the current market price and the strike price of the call option.
This covered calls for beginners approach isn’t optimal.
To understand why blindly selling covered calls isn’t ideal you have to understand what you’re giving up when you do so. The chart below, courtesy of the Options Playbook shows the payoff for a covered call: it’s capped at the strike price plus the premium received for selling the covered call.
If the stock price stays flat or goes up, you make money. But if it goes down more than the value of the premium you received, you lose money. While you’ll lose less money than someone who didn’t sell a covered call, it’s not much of a consolation prize when price drops 20 percent and you only lose 19 percent instead.
Markets don’t go up and down in a straight line so the downside of blindly selling a covered call with a strike price that is either at the current stock price or near it is that if price spikes up you get assigned, miss out on part of the gains, and have to either move on to the next stock that represents a better value, buy back in at a higher price, or hope that the stock price drops back to where you originally got assigned. In a raging bull market you miss out on gains.
To quantify how much a simple covered call strategy misses out in a raging bull market you can look no further than the BXM Index. This index systemically sells covered calls on the S&P 500 at or slightly above its current price and reinvests the premiums and dividends received. As the chart below shows, the index is up ~34 percent for the last five years ending July 16, 2019.
This compares to the S&P 500 Total Return Index’s return of ~68 percent. Even over a longer period like the last 30 years, the buy-write index has consistently lagged the S&P 500.
So why do investors use a covered call strategy if they seem to be better off just buying the underlying index? There are a couple of answers, most of which depend on the investor’s preference:
- Some argue a covered call strategy is a slightly smoother ride due to the premium received. While technically true, and you can kind of see it in the chart above, I think this is a terrible reason because a covered call strategy can still get cut in half and the difference in volatility on a day-to-day basis is imperceptible unless you get out a spreadsheet and run the numbers.
- It can improve behavior: an investor gets regular payments coming in. Like a dividend investor who only cares about the cash generated by their investment, they’re less likely to panic sell at the bottom.
- And for the true speculator, while it’s impossible to know when the buy-write index will outperform the underlying index, it doesn’t mean they can’t try to time it anyway.
But just looking at the returns from an at-the-money covered call strategy on a single index misses the point.
Covered Call Strategy for Income
For a trader who wants to make a consistent living, a covered call strategy for income can boost the cash coming in while lowering the risk of missing out on capital appreciation. The trick is to move away from writing covered calls on indexes and instead write them on individual stocks that make up the index. The downside to this approach is that it takes a much bigger pile of loot to implement responsibly. As an example, selling one covered call option on EFA requires ~$6,700 and gets you plenty of diversification. Selling one covered call option on CVS requires ~$5,500. However, if you sell covered calls on individual stocks you probably want to have at least 20 positions. If the average stock costs $55 then you need to have a $110,000 portfolio to minimize non-systemic risk (the math: $55 x 100 shares x 20 positions). If you want to make a concentrated bet feel free, but know that its more likely to end in tears.
The key to a covered call strategy for income is to combine fundamental analysis to identify the stocks that represent a good value with technical analysis to identify a good time to sell the calls.
Fundamental Analysis for Writing Covered Calls
There are myriad resources out there that will give you an estimate of fair value. Morningstar provides one such service while FastGraphs, which is what I personally use, is another. Very few non-professional investors have the time and the ability to generate a fair value estimate every quarter for a large group of stocks on their using using just an excel spreadsheet. Using shortcuts such as Morningstar or FastGraphs provides a consistent methodology to see whether a deeper dive into a company is warranted. These two services aren’t perfect – they only look at the numbers and don’t take into consideration changes in the marketplace, opportunities, or threats the company is facing, but it’s an easy starting point to identify companies that seem to be trading at less than normal value.
As an example, the chart below is the FastGraph for CVS. It contains an orange line, a blue line, and a black line. The black line is the stock price, the orange line is the “normal” market multiple of 15x and the blue line is the average p/e multiple that the market has assigned to the company over the period in question. Given CVS’s solid growth over the past 20 years the market has historically valued the company higher than normal market multiple of 15x.
While CVS: Turnaround or Value Trap goes into more detail as to whether I think CVS is here to stay or is going to get competed out of the marketplace, the chart quickly illustrates whether a company is trading under a long-term, normalized estimate of fair value based on TTM operating earnings. If it is, then an investor can take the time to dig deeper to understand whether it’s a good candidate to buy and run a covered call strategy for income on. While valuations based solely on TTM operating earnings do not work for every company (not even close!), it does work reasonably well for the large, well-established companies that you’ll want to focus on for a covered call strategy.
Technical Analysis for Covered Calls
Once a company has been vetted and you’ve purchased the initial shares, the next step is to use your favorite price-based indicator to time when to sell the covered call. A lot of fundamental investors are taught that technical analysis is voodoo and doesn’t work, and for the most part they’re right: very little of traditional technical analysis generates alpha. However, it is useful for timing covered call sales. The trick is to wait until price has spiked up and then sell the covered call.
As an example, the chart below shows the most recent 6 months of price action for CVS with various technical analysis overlays and indicators.
The chart shows a standard 20-period Bollinger band overlaid on price with a Relative Strength Indicator and Full Stochastics oscillator indicators above. As you can see, they all generally tell the same story so it doesn’t really matter which one you use. What the chart does help you do is more clearly see when to sell the covered calls. Whenever price tags the upper Bollinger band or your oscillator of choice goes into overbought territory, go ahead and sell the covered call.
If you wait to sell a covered call when price has spike up, and you sell one that’s at least 5 percent or more above the current price, you’ll improve your odds of generating current income while not missing out on capital appreciation. Doing it this way improves total return instead of the common covered call approach that focus only on current income.
Once you have sold the covered call after the price spike you get to do my favorite part of investing: walk away from your trading screen and go enjoy life. But seriously, this is an incredibly low-maintenance strategy as only one of two things will happen:
- Price declines: if it declines enough so the value of the call premium has dropped in half from where you sold it, go ahead and buy back the call to close it out then wait for price to spike again so you can repeat the process.
- Price goes up: if price goes above the strike price then congratulations, you just made money. Depending on how much extrinsic value is left in the call premium (extrinsic value is the value of the call premium less the strike price) you can either close out hte entire position or wait to get assigned. Think about it this way: if a month went by since you sold the covered call, you’re sitting on a ~9 percent gain, and you can either lock in that 9 percent gain now or wait another 2 months to eke out the remaining 2 percent extrinsic value that is left on top of the 9 percent you’ve already made, it probably makes sense to close out the whole position and move on to the next opportunity.
Buy low and sell high is a trading and investing cliche, but the above approach tilts the odds in your favor of actually accomplishing it.
Best Stocks for Covered Call Writing
Since risk management is achieved through diversification and position sizing versus stop losses it’s key to only run this strategy on large, high-quality companies that have a reason to exist, are likely to be around a long time, and aren’t extremely overvalued. The table below is a selection of companies from the S&P 100 that appear to be trading below their estimated long-term fair value and are not exhibiting negative momentum. The stocks in the S&P 100 tend to be the largest and most established companies in the United States and represent almost 51 percent of the market capitalization of the entire US equity markets.
The table above is updated quarterly. If you’re only interested in the stocks that warrant a deeper dive for a covered call strategy for income it can also be found at Best Stocks for Covered Call Writing with updates announced on Signalee’s blog.